A Theory and Test of Credit Rationing: Further Notes.

This article provides the author's comments on paper by economist Vernon Smith on the theory of credit rationing developed in Jaffee and Modigliani (J-M). Smith's paper generalizes our results to include the case in which the borrower's investment and hence his end of period value is explicitly a function of the size of the loan granted by the bank. It should perhaps be added, before turning to these issues, that Smith's contribution takes on further significance in view of the literature that has been concerned with the variable-size assumption. As it turns out, the general approach adopted by Smith parallels my analysis of the problem. In order for the analysis of credit rationing developed in J-M to remain valid under the variable-size assumption, the essential condition is that the three main characteristics of the offer curve remain unchanged. In the concluding section of his paper, Smith provides an analysis of credit rationing under conditions of Pareto optimality in the loan market. The analysis is restricted, however, in that the relative degree of market power attributed to the banks is not made explicit, and, consequently, the implications of varying degrees of bank market power cannot be developed.